Actually I should have said “your estimate” of equilbrium P/E is based on estimated inflation of 2%. I know that inflation changes, and along with it equilibrium P/E. My point is that you underestimate inflation – it is closer to 10-11%; it is not 2%. Therefore you have overestimated equilbrium P/E. Equilbrium P/E is around 10%, and therefore the market is NOT undervalued. Current equity prices are close to equilibrium and therefore there is no inherent force that would cause them to rise much beyond current levels.

My estimate of 10-11% inflation is based on the pre-1994 methodology, a methodology not characterized by overstretching adjustments – hedonistic and substitution adjustments, and the ridiculous notion that food and energy prices should not be included in calcluation of a “core” rate. Further my estimate is much closer to the growth of monetary aggregates relative to growth of real gdp.

Pardon my mistake in attributing your error to Peter Lynch. I spoke/wrote too quickly.

]]>Margaret, the “Rule of Twenty” is based on a changing inflation rate (i.e., the P/E multiple should be lower when inflation is high, and the P/E should be higher when inflation is low). This idea has been around even longer than Peter Lynch, and you can read more here: http://valuestockplus.wordpress.com/2006/10/31/the-rule-of-20/

]]>Lynch knows inflation is much higher than 2%, or at least he should know.

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